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Market Risk Review 2007

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Market Risk Review 2007 Market Risk Review May 2007 Prepared by the Financial Management Department Rev. 1 1 Introduction ... • The AfDB’s over-arching risk management philosophy is to maximize the risk bearing capacity available to support its development activities (core business risks). • One way to achieve this is to minimize exposure to non- essential sources of risk such as market risk (non-core risks). • The purpose of this presentation is twofold: – examine the Bank’s policies and guidelines for managing market risk and assess their effectiveness. – evaluate the impact of other policy changes on the way the Bank manages market risk. 2 • The Bank manages the various risks to which it is exposed within an over-arching risk management philosophy. The essence of this philosophy is to maximize the risk bearing capacity that is made available to support the Bank’s development activities (the Bank’s core business risks). To do this, the Bank seeks to minimize its exposure to other sources of risk that are incidental to the Bank’s development mandate (non-core risks). • Market risk is the potential for loss (either financial or non-financial) due to changes in market factors such as interest rates, exchange rates or liquidity and is considered a non-core risk by the Bank. Consequently, the ADB seeks to reduce to the extent possible its exposure to the various forms of market risk. • This presentation is the annual review of the Bank’s market risk management prepared for Senior Management and the Board. The purpose of this presentation is twofold. First, the presentation will review the Bank’s market risk management objectives and the strategies employed by the Bank to achieve these objectives. Second, it will assess the effectiveness of these strategies over the past year. 2 This presentation is organized in four parts… • Currency Risk • Interest Rate Risk • Liquidity Risk • Counterparty Credit Risk 3 • This presentation is organized in four principal sections. • The first section focuses on currency risk. It will show that measures taken (as part of the Bank’s financial reform program) have been effective in reducing the Bank’s exposure to movements in currency exchange rates. • The second section examines interest rate risk. It will demonstrate that the Bank’s interest rate benchmarks are performing as expected. • The third section of this presentation looks at liquidity risk. It will show that the risk of a liquidity shortfall for the Bank is negligible. • The fourth section examines the Bank’s exposure to counterparty credit risk arising from asset and liability management operations. It will show that although the growth in liquidity has increased the overall exposure, this exposure is increasingly limited to high quality assets. • Before getting into the core parts of this presentation, lets first briefly review the Bank’s framework for managing its exposure to market risk. 3 The AfDB Group’s market risk policies and strategies are managed under the ALCO control framework ALCO Control Framework ALM Authority Board President ALM Guidelines ALCO Processes Systems People 4 • The Bank Group’s market risk management policies and strategies are managed under the ALCO control framework (Asset and Liability Management Committee). The ALCO control framework is supported at three primary levels. In 1998, as part of the Bank’s financial reforms, the Board approved an umbrella document called the Asset and Liability Management Authority. This Authority was intended to link the various policies into an integrated framework. In 2005, the Bank’s market risk policies, covering currency, interest rate & liquidity risks, were fully integrated into the ALM Authority to create a single comprehensive policy document for market risk. • One of the key innovations of the ALM Authority was the delegation to Management of the authority to develop detailed implementation guidelines for the Bank’s asset and liability management operations. As a result of this flexibility, the Guidelines have been revised several times since 1998, with the latest update in 2005, to reflect developments in the capital markets and advances in the Bank’s capacity to manage its risks. • The third level of the Bank’s asset and liability management framework is the implementation structure. This structure consists of detailed processes that are implemented through advanced treasury IT control systems by a team of finance specialists. • The Bank’s ALM framework is continuously improving to meet industry best practices. 4 In the first part of this presentation ... • Currency Risk – Objectives – Policies & strategies – Effectiveness • Interest Rate Risk • Liquidity Risk • Counterparty Credit Risk 5 • The first part of this presentation looks at currency risk. Currency risk is the potential loss caused by changes in market exchange rates. • This section of the presentation begins by reviewing the Bank’s principal currency risk management objectives. It then examines the strategies employed by the Bank to achieve these objectives. Finally, it assesses the effectiveness of these strategies. 5 The AfDB strives to achieve two principal currency risk management objectives Currency Risk Management Objectives • Protect the Bank’s risk capital from translation adjustments due to exchange rate movements. • Protect the Bank from budget over-runs due to exchange rate movements. 6 • The Bank’s currency risk management policy strives to achieve two principal objectives. • First, consistent with the objective of generating steady growth in its risk bearing capacity, the Bank’s currency risk policy seeks to protect its risk capital from fluctuations in translation adjustments caused by currency exchange rate movements. • Second, the Bank seeks to protect its budget from cost over-runs due to exchange rate movements. As we will see later in this presentation, this risk arises because of differences in the currency in which the Bank reports its budget, the Unit of Account, and the currencies in which it actually makes its administrative expenditures. • These two sources of currency risk are examined in turn. 6 To protect risk capital from exchange rate movements, the Bank aligns its equity with the SDR basket Assets Liabilities USD USD EUR Equity UA (SDR) GBP EUR JPY GBP Equity JPY 7 • Since the Bank’s principal currency risk management objective is to stabilize the UA value of risk capital (the measure of risk bearing capacity), the Bank’s strategy is to align the currency composition of its equity with the currency composition of the SDR. Given the mechanical relationship between the value of the four currencies making up the SDR and consequently the UA, if the currency composition of equity is aligned with that of the SDR, then fluctuations in market exchange rates will have perfectly off-setting effects on the UA value of the Bank’s equity. • As illustrated graphically above, the Bank determines the currency composition of its equity by deduction. The first step is to determine the currency composition of its various asset portfolios (loans, investments etc). The next step is to compute the currency composition of its liabilities (mostly borrowings). The currency composition of the Bank’s equity is then computed by subtracting the currencies of liabilities from the currencies of assets. • Towards the end of 2005, as a result of the IMF’s review of the SDR basket (every 5 years), the currency composition of the SDR was revised, causing a sharp increase in the share of US Dollar in the basket at the expense of the shares of Euro, Japanese Yen and the Pound Sterling. Alignment trades have been executed accordingly in 2006. • Let’s now look at how closely aligned to the SDR benchmark the Bank was at the end of 2006. 7 The currency composition of the Bank’s equity is closely aligned with the SDR Currency Mismatch of Equity versus SDR* (Dec 2006) 1,0% 0,5% 0,0% -0,5% Deviation Deviation from SDR -1,0% USD Euro Yen Sterling Africa * as a percentage of equity 8 • The chart above shows the distribution of the Bank’s currency mismatches at the end of 2006. In an ideal scenario, the composition of the Bank’s equity would be limited to the four SDR currencies. In reality, however, the Bank has a small residual amount of African currencies that the Bank is unable to convert into the SDR basket. As a result, the Bank must live with a small residual mismatch that it seeks to spread out as evenly as possible across the four SDR currencies. • To maintain the currency composition of the Bank’s equity with the SDR currency basket, the Bank engages in periodic currency adjustment operations. For the most part, these adjustment operations generally focus on spot market (cash) conversions of liquid assets to maintain the desired alignment. Currency alignment transactions are approved each quarter by ALCO based on the analysis and recommendations of the currency risk working group. • As can be observed, the mismatches in all the main currencies were under 0.4%, indicating very close alignment. Let us now look at the actual impact this effort to minimize the currency mismatches has had on the objective of protecting the UA value of the Bank’s equity. 8 Despite high volatility in market rates, the effect on equity has been well contained Evolution of Translation Gains & Losses (as Dec 06) 10% 5% 0% -5% Year onYear Change Year -10% -15% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Translation Adjustments* USD/SDR exchange rate 9 * CCTA plus CEAS as a percentage of equity • The above chart presents the year on year percentage changes of the UA value of the Bank’s equity due to fluctuations in the currency exchange rates (bars) compared to changes in market exchanges rates (line) since 1986. The USD/SDR exchange rate is used as a proxy for market exchange rates.
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